Accounting treatment of closing stock

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on June 22, 2021

What is meant by Closing Stock?

Closing stock consists of different types of finished goods in case of trading business. Whereas in case of manufacturing business closing stock is consisted of raw materials, work-in-progress and finished goods.
The unsold closing stock of the current year is the opening stock of the next year. As the current year’s unsold closing stock will be sold in the next year, therefore, the cost of the closing stock is not an expense of the current year rather it will be the expense of the next year when it will be sold out, therefore, it is on the credit side of Trading Account.

Application of convention of conservatism

Whenever closing stock and other current assets such as short term investment in marketable securities etc are recorded they should be recorded at Cost Price or Net Realizable Value (Market Value) whichever is less. Because this convention lays down a rule “Anticipate no profit, but provide for all the possible losses”.

Example 1

Suppose, at the end of 2019, closing stock appears in the books at cost price of $25,000 but, its market price at that time is $30,000. The excess amount $5,000 is profit in “Anticipation” that will be earned only when stock will be actually sold in next year. Therefore, anticipated profit will not be considered and closing stock will be recorded at cost price of $25,000 which is lower than the market price or (NRV). Because the convention says “Anticipate no Profit”.

Example 2

Suppose, at the end of 2019, closing stock appears in the books at cost price of $25,000 but, its market price at that time is $22,000. When stock will be actually sold in next year there will be a loss of $3,000 (25,000 — 22,000). Although this loss will occur in next year when stock will be actually sold but, it is a “Possible Loss” therefore, it will be recorded in current year and closing stock will be recorded at market price of $22,000 which is lower than the cost price. Because the convention says “Provide for all the Possible Losses”

Reason for recording closing stock on credit side of trading account – The application of matching concept

To find out gross profit or gross loss direct expenses are matched with the direct revenues. All direct expenses are recorded on the debit side of Trading Account and direct revenues are recorded on the credit side of Trading Account. Closing stock is also recorded on the credit side of Trading Account which is revenue side. Is closing stock revenue? No! Closing stock is not revenue. It is recorded on credit side of Trading Account due to the application of “Matching Concept” only.
The cost of Opening Stock and Purchases is charged as an expense to Trading Account by recording them on the debit side of Trading Account. Revenue generated by selling them is matched against them by recording sales on the credit side of Trading Account. Expenses of certain number of units should be matched against the revenue generated by the sale of same number of units. If, however, there are some unsold units, their cost must not be charged to the Trading Account, therefore, their cost is deducted by recording them on the credit side. The concept can be understood better with the help of the following example:

Example 3

Suppose, 100 units of goods purchased @ $50 per unit. Total purchases of $5,000 (100 x 50) will be shown on the debit side of Trading Account. Suppose, if all the units are sold @ $80 per unit, then sales of $8,000 (100 x 80) will be recorded on the credit side of Trading Account. Gross Profit is $3,000 (8,000 – 5,000). Here, we are matching the Expense (purchase price) of 100 units with the Revenue (sales price) of 100 units that is quite logical.

Example 4

suppose, in the above example, if only 80 units are sold @ $80 per unit then sales of $6,400 (80 x 80) will be recorded on the credit side of Trading Account. If the closing stock of 20 units is not recorded on the credit side of Trading Account, the Gross Profit will be $1,400(6,400 — 5,000). This Gross Profit is not true, because here, we ap matching the Expense (purchase price) of 100 units with the Revenue (sales price) of 80 units. According to “Matching Concept” only those expenses are matched against the revenue, which are incurred to produce such revenue.
In this regard Expense (purchase price) of 80 units only should be matched against the Revenue (sales price) of 80 units. For this purpose Expense (purchase price) of 20 unsold units will be recorded on the credit side of Trading Account to reduce the expense of 20 unsold units. Here we are matching the Expense (purchase price) of 80 units against the Revenue (sales price) of 80 units that is quite logical. The true Gross Profit on sale of 80 units will be $2,400 (6,400 + 1,000 – 5,000).

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